The Bank of Japan surprised the markets by announcing widening bandwidth for the 10-year bond rate. A way for it to let bond rates slip without touching the key rates. Why and with what consequences?
Welcome inflation (up to a certain level)
In the face of soaring inflation, 2022 was marked by a general rise in key interest rates. Japan is an exception. Its central bank has been fighting deflation for decades. As a result, the increase in consumer prices to 2.5% this summer was not a cause for particular concern.
The growing interest rate differential between Japan and the other major industrialized economies severely weakened the yen as investors saw an opportunity. The much higher returns in supply elsewhere (especially in the United States) have led investors to abandon Japanese debt to the benefit of others, which is more profitable. And in the face of the disappearance of cheap credit elsewhere, the yen has become the currency par excellence of carry-trade, that investment strategy that consists of borrowing at low-interest rates to invest immediately in investments offering higher returns, keeping the difference.
Taken together, these factors have further strengthened the weakening of the yen towards levels of substantial undervaluation against the euro and the lowest in several decades against the US dollar. Here again, the Bank of Japan wanted to see the cut half full: a weak yen offers the «Made in Japan» an attractive competitive advantage. Therefore, it chose to keep its monetary policy unchanged for a while. However, the weakness of the currency also has negative consequences. The price of imported products, especially energy, ended up pushing inflation to 3.8% in November, an unacceptably high level for households in the archipelago not used to this phenomenon.
The Bank of Japan was therefore forced to change its monetary policy. Beyond a key interest rate, still at -0.10% at this stage, it also has the objective of an interest rate on the 10-year government bond at 0.0%, with a tolerance band. This band was modified from 0.25% to 0.5%. As a result, the 10-year Japanese rate can now go as far as this value. As a result, a policy rate hike – which will mean the end of negative rates - will take place in the coming months.
A new reality
This marks the end of the era of ultra-expansionary monetary policy in the country that has been its most loyal defender. This also changes the situation for the yen. So far, the carry-trade bet has been one-way, winning every time. But with Japanese rates on the rise and the yen appreciating, especially against the US dollar, it becomes much riskier. This reduces the pressure on the Japanese currency, which is picking up colours at the end of the year. This development reinforces our interest in the Nippon government bond.
Anchored by the omnipresence of the Bank of Japan in this market, the yield in offer remains very low, the 10-year yield being wisely at 0.45%, within the tolerance band authorized by the Bank of Japan, but much less than investors in Europe or the United States can find. But history changes if we consider Japanese inflation of 3.8%, against 10.1% in the eurozone.
The actual Japanese yield (after inflation) is, at 3.3%, much less negative than those offered on many other bond markets, especially in our countries. And since we estimate the undervalued yen by more than 20% against the single currency, we are betting on a gradual rise in the Japanese currency against the euro, which would inflate the total return of such an investment.
In addition, the Japanese government bond has a weak correlation with most other financial assets. It is, therefore, an exciting diversification for any portfolio at this stage.
A very diversified and cheap market
Of course, the rise in Japanese rates will not likely favour the Tokyo Stock Exchange. More expensive credit will weigh on Japanese investment and consumption, while the colourful Japanese yen weakens Japan's competitive advantage. But it is necessary to relativize first because credit will remain very cheap in Japan. Second, the strength of the Japanese market is its companies, whose horizons extend far beyond the archipelago and remain highly competitive at the world level.
Since Japan is poor in natural resources and has a highly skilled workforce that is becoming scarce due to an ageing population, the temptation to go and produce elsewhere in the Asian region is significant. But this choice is also strategic. Many countries in the region (Vietnam, Thailand, Indonesia, or the Philippines) are essential for strengthening and diversifying production chains, but also because their size makes their markets of choice for "Made in Japan", which they are fond of.
By investing in the region and helping improve living standards, Japanese companies are creating tomorrow's consumers. This allows Japanese companies to participate - and benefit - from the entire region's growth.
The strength of the equity market also results from its strong diversification. While industrial stocks and consumer discretionary goods are at the top of MSCI Japan, accounting for 22% and 18% of the market, respectively, information technology (14%), finance (11%) and health (10%) and communication (8%) are all well represented. In addition, the Tokyo market remains the least volatile in our selection since it traditionally offers refuge to investors when nothing goes well.
Rich in savings, many Nippons invest their money abroad to obtain greater returns than those offered on the archipelago. But in times of great tension, they tend to withdraw en masse from foreign markets, repatriating their capital. This translates into an appreciation of the yen and increased demand for local assets (and thus higher local asset prices).
Despite recent gains, the yen has lost about 8% of its value against the euro since the beginning of the year. Nevertheless, even at the current level, the Japanese currency is cheap and contributes to our interest in cheap Japanese equities.